Italy Pushed Closer to Financial Brink

A day after Prime Minister Silvio Berlusconi offered his resignation in the face of rising global market skepticism, investors revolted Wednesday, suggesting they do not believe that even a new leadership could fix Italy’s intransigent financial problems and revive its economy.

Italian bond rates crossed a crucial level of 7 percent, prompting questions about whether Italy could soon need an international bailout just as the financially strapped nations of Greece, Ireland and Portugal did before it.

The difference this time is that Italy, the third largest economy in the euro zone, is on a different scale than those other, much smaller European nations. That means any bailout would have to be proportionately far larger, and some analysts question whether the European Union or the International Monetary Fund have enough resources to pay for it at all.

“This is a new phase of the crisis,” said Nicolas Veron, a senior fellow at Bruegel, a research organization in Brussels. “This is uncharted territory.”

In a worst-case situation, Italy might possibly be even forced to abandon the euro. The departure of a nation the size of Italy from the single currency would potentially have far more devastating effects on the euro area than that of a small country like Greece.

But Italy may not be at the precipice yet, analysts say. Even though its nearly 2 trillion euros, or $2.7 trillion, in debt is worth 120 percent of its gross domestic product, it is a far stronger and wealthier economy than Greece or the other smaller nations. Italy’s relatively small budget deficit compares well to some other larger nations elsewhere in Europe, like Britain.

Italy could withstand interest rates at this level longer than weaker countries like Greece, analysts say, and there are a number of things that may yet happen to ease the crisis — for example, if Italy elected a new government credibly committed to fixing its debt woes and restarting growth. Also, European leaders could more clearly formulate the terms of a proposed, much-vaunted bailout fund and put it to work, or the E.C.B. could step in more vigorously to buy Italian debt.

“Italy is not nearly in as bad of a situation as some observers may suspect,” said Marc Chandler, an economist at Brown Brothers Harriman.

The sharp market moves sent shudders across Europe, raising concern that this could be a moment when its markets would finally seize up in the way they did after Lehman Brothers collapsed in the United States in 2008. But they did not appear to set off quick policy reactions from European officials or, apart from bond buying by the European Central Bank, by central banks around the world including the Federal Reserve.The new euro-era record for Italian bond yields of 7.48 percent is close to the level that earlier prompted financial bailouts for Greece, Ireland and Portugal. One of Europe’s big clearing houses, where traders settle bond purchases, raised its margin requirements in response to the perceived increased riskiness of Italian debt, further unnerving investors.

The stocks of European banks that hold large amounts of Italian debt fell. And the cost of insuring Italian debt as measured by credit default swaps rose to record levels.

The bond interest rates later fell back slightly to about 7.3 percent, but only after the European Central Bank was reported to be buying Italian bonds again. This suggests many private investors are fleeing Italian debt, raising worrying questions about how Italy will finance itself when it needs to sell billions of dollars of debt at a key auction next week.

A spokesman for the International Monetary Fund said Wednesday that the fund currently had no plans to offer Italy financial assistance.

“It’s really up to Italy to act,” said one European official, who spoke on the condition of anonymity. Another senior European official, who also spoke on condition of anonymity, said: “It’s not a time for bailouts, it’s a time for them to implement policies.”

There is a feeling among several European leaders that all the E.C.B. buying so far has only allowed Italy to stall its fiscal and political reforms, and perhaps the market pressure on Italy is needed to make its government react as it should, the officials said.

The crisis in Italy started in July when investors began to fear financial contagion could spread from Greece. As bond yields began to march steadily higher, the European Central Bank stepped in to buy Italian debt.

With French banks among some of the biggest holders of Italian debt, the fear is that the crisis could now spread forcefully from Italy into the heart of the euro zone. French yields also rose worryingly on Wednesday to above 3 percent.

The only way to save Italy and stop the contagion, many economists believe, is for the E.C.B. to buy Italian bonds on a much more aggressive scale than it has so far been prepared to do. But while the E.C.B. will not let the euro fail, analysts said it would avoid bailing out Italy as long as possible, to keep the pressure on Mr. Berlusconi and other Italian leaders to make reforms by cutting spending and removing impediments to growth.

Italy poses “the real danger to Europe and the world economy,” Barclays Capital said in a research note. “Yields on Italian government debt have reached new highs, and are at levels that we consider clearly unsustainable.”

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TimesCast | Italy's Financial Crisis

As painful as a Greek default would be, the world economy faces a much graver threat if investors abandon Italian debt and the cost of borrowing for the Italian government becomes prohibitive. Italy is the world’s fourth largest borrower after the United States, Japan and Germany. Indeed, it owes more than the other troubled countries on the periphery of Europe — Greece, Ireland, Portugal, and Spain — put together.

On the Continent, French banks are the most exposed, holding more than $100 billion worth of sovereign Italian bonds and on the line for another $300 billion loans to private borrowers like Italian companies and consumers.

French banks are heavily exposed because they moved aggressively into Italy over the last decade buying Italian rivals, and operating extensive branch networks. BNP Paribas, which bought Italy’s Banca Nazionale del Lavoro five years ago, holds 12.2 billion euro worth of Italian sovereign debt, despite reducing its Italian bond holdings by 40 percent since the summer.

Shares of all three French giants were down more than 2 percent in trading in Paris on Wednesday.

French banks could also serve as transmission lines for problems at American institutions if the debt crisis on the Continent worsens. Unlike Greek banks, or even Italian banks, French banks are global giants who trade hundreds of billions of dollars each day with their American counterparts, especially through complex derivatives trades where Société Générale and BNP Paribas are among the world’s biggest players.

Indeed, the heightened European fears took a sharp toll on American bank stocks Wednesday. In midday trading, shares of Citigroup were down 5 percent, while JPMorgan Chase was off 4.3 percent.

A senior investment banker at a large European institution said that the E.C.B. was buying some Italian bonds on Wednesday, but the amounts were not large. But another banker in London said the E.C.B. had bought an estimated 2.75 billion euros in bonds on Wednesday, of which 2.5 billion euros was Italian debt, a large number by E.C.B. standards.

According to one Rome-based banker who speaks regularly with the Italian government, it has been foreign investors more than their local counterparts that have been the majority sellers of Italian debt. He pointed to two main reasons for this: the fact that the European Banking Authority is making a push for European banks to mark their sovereign debt to market levels as well as increased margin requirements from clearing houses.

But analysts point to another factor as well. Italy is the only country among Europe’s weaker nations that offers investors the opportunity to buy or sell futures contracts tied to Italian bonds. Though the feature was presented initially as a way for investors to hedge their exposures, investors who want to make a negative bet on the euro zone can sell Italian bond futures — which adds to the already significant downward pressure coming from investors who are unloading their bond holdings directly.